Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Actually, I understand why; the inflation hawks are still a powerful force that must be appeased. But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better. Even the chief economist at the IMF says so. (OK, in real life it’s Olivier Blanchard, who is a very smart and also flexible-minded macroeconomist who just happens to be at the IMF for now — and I’m glad that he is!)

Comments:

1. The "inflation hawks" are NOT a powerful force on the FOMC. The Committee just voted, with one dissenting vote, to keep the target for the fed funds rate in the range 0-0.25% until the end of 2014. That's hardly a hawkish policy, and the Fed has already engaged in some massive and unprecedented quantitative easing, that is far from hawkish and conservative. Indeed, it is quite risky, and favored by the majority of FOMC members, who are basically old and new Keynesians, if they know any economics at all. Actually, the moniker I would prefer to apply to the "inflation hawks" is "serious economists" (for the most part - Fisher is not an economist).

2. The Blanchard paper that Krugman is referring to is this one. Here is what it says about the central bank's inflation target:

The crisis has shown that large adverse shocks can and do happen. In this crisis, they came from the financial sector, but they could come from elsewhere in the future—the effects of a pandemic on tourism and trade or the effects of a major terrorist attack on a large economic center. Should policymakers therefore aim for a higher target inflation rate in normal times,in order to increase the room for monetary policy to react to such shocks? To be concrete, are the net costs of inflation much higher at, say, 4 percent than at 2 percent, the current target range? Is it more difficult to anchor expectations at 4 percent than at 2 percent?

The paper goes on to discuss the costs of the inflation, in more-or-less standard textbook terms. There's nothing new there. So, did Krugman actually read the paper or not? It doesn't really matter. The key point is that Blanchard is not recommending anything, he's just asking a question. There's no report on any research to answer the question; this is just Blanchard musing with his staff about how recent history might change how we think about monetary policy. Thus, Krugman's statement that "Even the chief economist at the IMF says so," is false.

But what of Krugman's argument? Krugman says (repeating the above):

But the truth is that recent experience has made an overwhelming case for the proposition that the 2 percent or so implicit target prior to the Great Recession was too low, that 4 or 5 percent would be much better.

He certainly seems convinced; "truth" and "overwhelming" are strong words. It's hard to see why, though, and he doesn't tell us. If you read Blanchard's paper, and look for the reasoning, you might see what Krugman has in mind. The basic idea is that a higher inflation rate gives the central bank more room to move. By Fisherian logic, if the real interest rate is constant in the long run, and the long-run Fisher effect holds, the long-run nominal interest rate will rise one-for-one with the long-run inflation rate. Having more room to move means that, if you subscribe to New Keynesian logic, then if the long-run inflation rate is 4% rather than 2%, on average you have an extra 2% by which you can lower the central bank's nominal interest rate target so as to correct sticky price distortions. There are at least 3 problems with this:

1. This presumes that the long-run costs of inflation are negligible, but to me this looks like an argument for wearing a sweater in July. You can always take it off if you want to cool down. I have written more on the costs of inflation here. Potentially the long-run costs of inflation are much larger than conventionally measured. Anyone who lived through the 1970s or, even better, comes from a country with a serious inflationary history, understands that inflation is bad.

2. If the key macroeconomic inefficiencies we are faced with are the relative price distortions coming from sticky prices, those inefficiencies might more appropriately be corrected with fiscal policy than monetary policy. Krugman seems to be thinking that the zero lower bound is a big problem, but the zero lower bound need not bind.

3. Blanchard, like Krugman, seems to fear the zero lower bound because bad stuff can happen there. Well, we have been in our modern-day liquidity trap for more than three years now, and apparently we have not yet been sucked into the deflationary vortex with ever-increasing output gaps that these characters seem to be concerned with.

20 comments:

There's a paper by Yuriy Gorodnichenko that directly addresses Blanchard's question within the context of New Keynesian models. He finds that even when costs of the zero bound are high, the optimal inflation rate in these models is typically below, but near, 2%. So even in models that satisfy Krugman's priors, quantitatively his conclusions don't follow.

No, he wasn't. There was a kind of central banking talent the guy had, though, that Bernanke does not.

"Nor is anyone else who did not see the rise in housing prices and private debt as a weapon of mass destruction"

That's a tough one. There's not much to be gained from arguing over who saw it coming and who didn't. The key point is to understand what actually happened. I don't think Krugman or Blanchard do. For example, the housing "bubble" was not a speculative phenomenon driven by monetary policy. It was the result of poor regulation at several levels in the financial system that essentially produced a large increase in the demand for housing, built on false pretenses.

"it will pay down and deleverage all that private debt faster."

That is true. Two problems with that, though. One, it's simply a redistribution from creditors to debtors. You have to worry about what it does to the creditors. Further, if you want to do that redistribution, you can do it more effectively with fiscal policy. Two, if debtors understand that they can run to the Fed to ask for more inflation every time they get in trouble, that creates a long-run moral hazard problem.

"The "serious economists" you talk about are only aiders of Steve Forbes and the gold bug/deflation now crowd, who would profit from crushing what little is left of this country for most Americans"

Nope it doesn't. As there is a trade-off between inflation and unemployment inflation hurts bondholders and benefits workers.

So behind this trade-off there is a conflict of interest that explains why people on the right favour low inflation whereas people on the left favour moderate inflation.

About moral hazard (I prefer the more technical term adverse incentives), this is indeed a theoretical problem of inflating yourself out of debt. I doubt that it is empirically relevant though, at least not in comparison to enduring a depressed economy with two-digit unemployment rates.

You measure talent by the end result. He pursued policies that resulted in the Lesser Depression and destroyed the future for 99% of Americans. I have many thoughts but would never have used the word, "talent."

As for "redistribution," using inflation to bring down private debt is no more redistribution was Greenspan permitting housing prices and private debt to explode, which was nothing but redistribution from debtors to creditors (interest never sleeps)

Your statement that debtors running to the Fed creating a moral hazard problem pins the moral hazard problem on the wrong tail.

The refusal of the Fed to create a moral hazard for creditors by using inflation to cancel bad loans encourages bad loans and lending practices.

As for your comment that inflation hurts everyone, that is exactly why inflation is the way to go.

You favor a "solution" that is no solution, but does preserve and the wealth, income, and power of the 1%. Inflation makes everyone pay the piper.

The course you propose is a lost decade, a failed economy, like Japan.

I agree. That is why I now read and comment on economic blogs, taking time to point out what is unsupported bias, prejudice, and mendacity.

I may not be able to do all the math, but I can recognize a turtle on a fence post (i.e., people like Cochran who are bucking for a place at the table should Obama get beaten). I see you as a turtle.

I made a terrible mistake. I assumed both some institutional control and academic integrity in the profession, learning to late that both are non-existent.

I knew that free trade and tax cuts (both leading to massive underinvestment) were hollowing out the country and lives of the people familar to me (and that home building wasn't a real business) but I hoped such was being offset elsewhere in the States.

However, we have lost our basic morality (it is acceptable to us that our beloved iPhones are made in sweatshops that feature domitories and a single glass of tea and a bisket). Yet, 150 years ago, during the Civil War, Great Britian stopped buying cotton from the Confederacy because it was the fruit of slave labor.

You buy what you want, and I'll buy what I want. I want an iPhone produced in a sweatshop, because it is inexpensive. You don't like it? Tough noogies for you, I'm going to buy another one just to spite you.

Well these sorts of insults are to be expected once one starts tossing off ad-hominems like "serious economist..."

Krugman was actually pointing to the following statement by Blanchard:

"Higher average inflation, and thus higher nominal interest rates to start with, would have made it possible to cut interest rates more, thereby probably reducing the drop in output and the deterioration of fiscal positions."

This quote was one link away from Krugman's blog post, and is substantially stronger than the one Williamson cites.

Also, simply because policy isn't what Prof. Williamson would like does not mean the inflation hawks are not a powerful force on the FOMC: considering that the "doves" want 4-5% inflation and the broad campaign for NGDP targeting last fall, one could argue that they are an effective counterbalance to the doves. As such "powerful" is in the eye of the beholder.

Finally, I am always somewhat surprised when Prof. Williamson seems ot be AOK with the state of the economy, which is being sustained by unemployment assistance to millions and payroll tax cuts while deleveraging slowly works through. As such, we can expect weak output growth, social-fabric-fraying levels of unemployment and high sensitivity to shocks for the next 3-8 years. Mocking those who find this situation unacceptable by saying, "well we're not trapped in a deflationary spiral" seems really weird, in this sense.

We would all like a better world. Currently, there are no actions the Fed can take to, for example, make the world look like it did in 2006. The Fed can certainly make the world a worse place, and I think their recent actions have the potential to do that.

I have no interest in the World of 2006, for I believe the economy was already sick then. I date our falling off the cliff to the Bush tax cuts. Actually, per Drugger, I really date our falling off the cliff to our totally improper responses when China devalued. You, probably, have never read Drugger.

My concerns really aren't macro at all, which I see as only being a tool to restore confidence and vision. You cannot have people sitting idle and only "fiscal stimulus," in some form, can put people to work.

My true concerns are our extremely low levels of public and private spending on R&D, investment, and education (all measured as a percent of GDP) and our extremely high private debt and our totally irrational approach to energy/energy costs (who can run a complex business with the GAP in your budget for energy costs that rise like oil?) (about which the Fed can do nothing).

Everything has been "crowded out" by health care, yet we never hear you talk about all of that business which is no different that Keynes "make work"